Wednesday, 19 January 2011

EconTalk this week

Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts on some of the common misunderstandings people have about prices, money, inflation and deflation. They discuss what is harmful about inflation and deflation, the importance of expectations and the implications for interest rates and financial institutions.

Here is part of the transcript of the beginning of the interview. It makes some simple but important points about prices changes, inflation and deflation.

Intro. [Recording date: January 10, 2011.] Inflation and deflation. Let's talk about inflation, what is usually meant and what we mean as economists. You asked the right question to begin. The definitions of inflation and deflation have changed over time, and in ways that are significant. The original meaning of inflation was an increase iin the money supply. There are still a few people today who hold out for that definition. I'm much more of a spontaneous order guy when it comes to language--words mean what people take them to mean. In fact, inflation today means, to the average person here, even the typical well-informed professional economist who uses it, not an increase in the money supply, but a sustained increase in the general price level--a sustained increase in average prices. But it's important to remember what inflation originally meant, because there's a connection of course between changes in the money supply and changes in the price level. Similarly with deflation. Deflation originally meant a decrease in the supply of circulating medium, and now it means a general decrease in the price level. Let's start with one of the common confusions. Much of the confusion about these two topics of inflation and deflation--really one topic, the average level of prices and their movements--one of the sources of confusion is how the media writes about it. Want to talk about two issues. One is they'll often talk about inflation in one price or deflation in one price. Generally, economists are very careful to distinguish between inflation--which is the average level of prices going up--as opposed to one particular price going up. That's one important confusion; think comes from misuse of the word "inflation" in the media. The other, which is related, is the media often reports, and the government sometimes collects--or always collects, I don't know--the core level of inflation, where they'll exclude certain goods. I think the core level is the level of inflation not including energy prices and food, say. Yeah, I've never understood that. It's a meaningless concept. And yet, it's commonly used. Why is it a meaningless concept? First, let's talk about the first issue--the difference between changes in the average level of prices, general level of prices, and changes in individual prices. It is important to distinguish between changes in individual prices--changes in one price relative to the price of something else--and changes in the price level. The concept to keep our eye on is--we have to ask why does the price change? Inflation becomes salient, becomes a meaningful and interesting concept to study when we recognize that prices are changing not because of any changes in real resource constraints, real consumer demands in the economy, real shifts in consumers' preferences for savings as opposed to consumption--but changes simply caused by exogenous increases in the supply of money. That is inflation. You are correct--a lot of the time people use the term "inflation" quite mistakenly to talk about individual price increases: "The price of gasoline is inflating." Or: "There's been a lot of inflation in the energy sector this year." That's quite confusing and nonsensical talk. If what is meant by "There's been a lot of inflation in the energy sector this year" simply means that the price of energy has risen relative to other goods, all that means is that the supply of energy resources has fallen and/or the demand for those resources to increase, which of course causes their relative price to increase--and their relative price should increase to reflect those underlying real changes in the economy. There's nothing about changes in the money supply that we would expect to show up exclusively in the energy sector, or any other individual sector for that matter. Similarly, the idea that they could somehow on their own ripple through the economy and cause inflation in the absence of a monetary change is unlikely and not really economics, the way you and I were taught it. Underlying what we are going to talk about today is the Milton Friedman sentence that "Inflation is everywhere and always a monetary phenomenon." It used to be people had many theories as to why the average level of prices would increase or decrease. It may be one of the few if not the only area of economics where decisive empirical evidence established a theory that virtually all economists--mainstream and out-of-the-mainstream--accept. In the 1960s there was an idea of wage-push or cost-push, even into the 1970s--this idea that unions could push up the price of labor and since labor is in every commodity. What the monetarists responded was--well, some prices will go up more than others because of their labor component, but sectors that are not unionized would then have decreases in prices in the absence of a monetary change. Just to take another example from the news, I think you often hear people say: What's all this talk of inflation? TVs are getting cheaper! TVs and other electronic goods--there's so much technological improvement in the production of those goods that their relative price has fallen dramatically. Had there not been inflation, it would have fallen even more. The nominal price would have fallen even more. If the average price level had been unchanging--if there had been no inflation over the last 25 years--then the goods that had the most technological increases would have even bigger nominal--meaning the dollar amount that we actually see that is not corrected for any kind of inflation, the actual number written on the price tag in America, say--would be even lower. But if there's inflation--if the money supply had increased enough over the last 25 years--you could have TVs and other goods getting more expensive in nominal terms--that is, the price written--but relative to other things getting dramatically cheaper, which they have, because of the technological changes. That concept is very tricky. Hard for people not used to thinking that way to see it. The real changes you are talking about get tangled up with these overall changes in prices as a whole because of changes in the money supply.